Value stock investing pointers: look at goodwill and investment quality, and look beyond financial indicators
When you begin investing, you may think the secret to investment profit is “buy low, sell high.” But that’s hard to do. You’ll often buy just before prices fall, or sell just before they rise. If you stick to high-quality value stock picks, however, your short-term gains and losses can average out and you’ll still profit greatly in the long run.
Ultimately, investment success in value stock investing depends more on the quality of your investments than on the price you paid for them.
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Goodwill: Consider the cost when engaging in value stock investing
In analyzing a company’s financial statements, a key concern, and a potential pitfall for investors, is the amount of goodwill that it carries as an asset on its balance sheet. Goodwill is an accounting entry that reflects the price that the company paid for its acquisitions, minus the value of the tangible assets, like land and equipment, that it received as part of the acquisition. The term means “value as a going concern.”
In the right circumstances, goodwill can be extremely important to value stock picks, especially if it is “off-the-books” goodwill—that is, goodwill that a company developed through its own efforts, which does not appear on the balance sheet. Examples include the value of the company’s brand, or the reputation and relationship that it has built up with customers over the years.
Goodwill writeoffs can have big consequences on value stock investing
Goodwill acquired in an unwise acquisition can lose value overnight. When that happens, the company has to write it off against earnings. At worst, the company might have to write off most, if not all, of its goodwill.
If that writeoff wipes out most of the company’s shareholders’ equity, and/or most of a year’s earnings, it can devastate the value stock pick’s share price. In most cases, that’s a cost-if-something-goes-wrong to avoid at all costs.
Value stock investing: Look beyond financial indicators
When they first set out to formulate a plan, many investors decide to base investment decisions on a handful of measures. For instance, they may want to see a p/e ratio (the ratio of a stock price to its per-share earnings) below 15.0, say, along with an earnings growth rate of 20% or more annually, and perhaps a 2% dividend yield.
This approach worked a lot better in the pre-computer age, when investing was more labour-intensive. Few people wanted to dig through old newspapers, annual reports and other material to get at the data. So more gems were left to be found by those willing to do the work.
Today, if you find a stock with this (or any comparable) combination of favourable ratios, it probably comes with some more-or-less hidden drawback not covered by your system. Instead of steering you away from investments that you don’t understand, or that harbour hidden risk, this system will steer you toward them.
Focusing on investment quality is the key to finding bargain stocks with gains ahead
The best investment plans or systems use a variation of our value investing approach. That is, they revolve around choosing high-quality investments and diversifying your holdings. Our three-pronged value investing program takes that general description a little further.
There’s no easy answer to the buy-now-or-wait dilemma. At times it may pay to hold off—for instance, a company’s stock will often rise when it announces a stock split, then fall after the split takes effect.
In the end, if a stock is truly worth investing in, you should be willing to buy it at current prices, even if that means you run the risk of having to sit through a 5% to 10% setback. Before it puts on its next 5% to 10% setback, after all, it may first go up 50% to 100%.
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